Corporate Taxation and the Quality of Research and Development

In this paper, we analyze the impact of corporate taxation on the location of corporate R&D activity. It is well known that corporate taxes negatively impact on the quantity of corporate R&D investment. Our results suggest that beyond a negative quantity effect, corporate taxation also distorts the location of R&D projects and assets of different quality, i.e. different innovativeness and revenue potential, across countries. To motivate our empirical analysis, the paper develops a simple theoretical model of a multinational group that operates afiliates in different countries and decides about the location of heterogeneous R&D projects. As R&D income becomes part of the local corporate tax base, the MNE has an incentive to distort the location of its projects in favor of low-tax afiliates (quantity effect). This incentive moreover turns out to be larger, the higher the technology's earnings potential. Low tax countries thus attract projects with an above average degree of innovativeness and value compared to hightax locations (quality effect). Importantly, a similar effect is not derived for R&D tax credits and allowances as their benefits are related to the size of R&D expenditures instead of (expected) earnings.

To empirically assess these hypotheses, we construct a rich data set which merges information on corporate patent applications to accounting and ownership data for European multinationals. Using this data, we derive an index for patent quality from a factor model that employs information on the patent's forward citations, the size of the patent family and the number of industry classes. Accounting for observed and unobserved heterogeneity between corporate entities and host countries, our empirical analysis suggests that patent income taxation significantly impacts on the quality of patents invented in a country. An increase in the patent income tax rate by 10 percentage points is found to reduce patent quality by around 5.6%. In line with the theoretical prediction, we do not find a statistically significant impact of R&D tax allowances and tax credits on patent quality though.

Our results complement the literature on tax policy choices and the location of innovative activities. Previous papers have suggested that R&D tax credits and allowances as well as patent income taxes significantly impact on the quantity of R&D activities. Our paper in turn suggests a fundamental difierence in the effect of these policy instruments on the quality of attracted R&D projects. While low patent income taxes are found to attract projects with an above average quality, such a positive selection effect is rejected with respect to R&D tax credits and allowances.

Ernst, Christof, Katharina Richter and Nadine Riedel (2013), Corporate Taxation and the Quality of Research and Development, ZEW Discussion Paper No. 13-010, Mannheim.